2014 edition of UK Corporate Governance Code

23 October 2014

In this update, our team considers your revised obligations on directors' remuneration - what has changed, what has not, the emphasis now required, the alternatives open to you if "comply or explain" leaves you needing to justify why the Code was not followed and a focus on the practical problems the revised Code presents.

Background

The Code has operated for almost 20 years as part of a framework of legislation, regulation and best practice standards which aim to deliver high-quality governance within a flexible framework which can be adopted by companies to meet their own needs.

Increasingly there has been a focus on transparency and the long-term viability of the business. Add to this the increased focus on directors' remuneration and the approval of remuneration policy by shareholders and the result is the revised Code which came into effect on 1 October. Investors will now be looking to see how the revised Code is implemented.

Guiding principles unchanged

The Code is not mandatory; it is not a rigid set of rules which must be followed. The approach has always been, and remains, one of "comply or explain". The Listing Rules require that companies apply the Main and Supporting Principles of the Code, and the Code Provisions, and report to shareholders on how that has been done.

It is open to the Board to explain any alternative approach - in clear terms and with evidence of its rationale for taking that alternative approach and how that has met the requirements for good governance set out in the Main Principles.
So, if you want to take a different route you can still do so, but you have to explain why you have done it and why the company, and its shareholders, are at no greater risk than they would have been with a compliant approach.

On the other hand, shareholders, who can challenge the Board's approach, are expected to do so in the spirit of "comply or explain" - so, rather than simply rejecting the proposal for being non-complaint, they need to consider the Board's rationale and the outcome.

The Code only applies to those with a Premium listing but there will be investors who would expect those who are exempt either to adopt the provisions voluntarily or, at the very least, be seen to consider and adhere to the Principles.

Remuneration Committee (Remco) obligations - the level, components and procedure for setting remuneration policy.

There are two Main Principles, D1 and D2, the first of which has been revised under the new Code:

"D1 Executive directors' remuneration should be designed to promote the long-term success of the company. Performance-related elements should be transparent, stretching and rigorously applied."

"D2 There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration."

A change in focus

The revised D1 now focuses on the connection between remuneration, the promotion of long-term success (a recurring theme in the revised Code) and the rigorous application of transparent and stretching performance components.

This is a very different vision to the old Code's references to "a significant proportion of executive directors' remuneration should be structured so as to link rewards to corporate and individual performance" with the long-term view being only a Supporting Principle.

The change of emphasis is one of philosophy - the business imperative is not just corporate performance but "the long-term success of the company". For the Remuneration Committee any element of the executive remuneration package which focuses on short term delivery, so in a reference period under three years, will need to be explained.

That does not make it impossible - there may be a business imperative that must be addressed and for which shareholders can see and benefit from it being achieved, but it has to be seen as part of an overall plan, not just opportunistic short-term profit generation.

There is more detail about the new focus in Schedule A to the Code

  • there should be a balance between fixed, performance -related, immediate and deferred remuneration performance conditions, including non-financial metrics, should be relevant, stretching and designed to promote long term success
  • remuneration incentives should be compatible with risk policies and systems
  • there needs to be consideration of annual bonuses as part of a long-term incentive plan
  • consideration should be given to share schemes obliging directors to hold a minimum level of shares and to hold shares for a minimum period after vesting/purchase, and to hold shares even after they leave
  • finally, and consistent with the long-term view to be taken, shares are not to vest and options are not to become exercisable within less than three years and "longer periods may be appropriate"

Clearly there will be cases where elements of the remuneration policy come under scrutiny - but, if they can be justified and meet Main Principles D1 and D2, those elements and the whole policy are going to be acceptable.

The right to claw back or withhold payments

The revised Code Provision D1.1 requires that:

"schemes of performance-related remuneration... should include provisions that would enable the company to recover sums paid or withhold the payment of any sum, and specify the circumstances in which it would be appropriate to do so."

This is a major change. In future not only does Remco have to look at the long-term nature of performance and incentives, it has to build in recoupment or avoidance mechanisms if doubts are raised about the payments.

It is unclear how these are to be defined - will it be about accounting error, fraud and/or short-termism at the expense of sustainability? Some of the practical issues are explored later in this note.

The avoidance of conflicts

Remco's very existence is designed to ensure that executive directors are not setting their own remuneration. This is made more explicit with the change to Supporting Principle D2:

"The remuneration committee should take care to recognise and manage conflicts of interest when receiving views from executive directors or senior management, or consulting the chief executive about its proposals".

This puts into the Code a specific obligation to ensure that Remco is independent. It is understandable if, at times, such independence is difficult to maintain given the proximity that senior non-executive directors (NEDs) will have to the executive management.

A failure to maintain this degree of independence could, however, leave the Remco members, and their proposals, open to challenge. This presents further challenges in recruiting NEDs who need to be - and be seen to be - above such influence.

Increased responsibility on Remco chairman

As the relevant remuneration policies now go before the shareholders for approval it is possible that there will be resistance from time to time. In practical terms, the Remco chair will need to explain the position and the rationale - nothing changes in that respect. But, under the revised Supporting Principle D2, the chairman of the board "Should ensure that the committee chairman maintains contact as required with its principal shareholders about remuneration".

The apparently slight change points to an active programme of contact, especially where there is to be any change in the policy. In some senses this does no more than make obligatory what many would see as good practice anyway - if Remco want to get the remuneration policy approved they will need to justify it in terms of the company's viability and the return to the shareholders.

Enhanced diversity at Board level

The revised Code identifies the benefits to any organisation of avoiding "groupthink" and identifies diversity of board membership as ones of the ways of encouraging constructive debate. What it does not do, at this stage, is impose specific obligations on companies as to what "diversity" needs to look like.

There is clear reference to diversity of "approach and experience", which the preface to the Code makes clear is not confined to questions of gender or race. It can therefore be inferred that the word diversity applies equally to educational, sectoral or professional expertise.

The next revision of the Code, in 2016, will come shortly after the fourth and final progress report of Lord Davies and the target of 25% women on FTSE 100 boards. The next revision will be taking that progress report in to account.

The direction of travel in terms of compliance, and the business benefits derived from more diverse boards, is clear. To complete the picture, the Council of the EU adopted a new Accounting Directive on 29 September, which will need to be introduced into English law by October 2016, which will require reporting on diversity in larger companies.

So even if greater diversity is not mandatory now it ought to be assumed that it is going to become a requirement in one form or another and you will be required to report on what is being done.

Action points

As the revised Code is in operation already here are some action points:

  1. Review the terms of reference and operating procedures for Remco. Who is on it, what are their actual or perceived connections to executive directors and, most importantly, how do they gather information on which their decisions are based?
  2. Update the chairman of the committee on the expanded role he needs to be able to play in relation to contact and discussion with principal shareholders.
  3. Review remuneration policy - does it meet the new provisions is Section D? If not, is it going to be changed or does the company adopt the approach of "explain not comply"?
  4. If the company is going to attempt compliance, or even if it wants to avoid change but needs to understand the extent of its non-compliance, a review of all the remuneration schemes in place needs to be undertaken. How do salaries rank in the market? What is the balance between short, medium and long-term incentives? What are the vesting periods for share options and other share awards?
  5. Few current schemes contain claw-back or withholding provisions. How far does the company want to go? If action is needed, is there a right to introduce those provisions in to the schemes in any event? Could any change be deferred until the current scheme(s) unwind? Would claw-back apply to shares and/or the proceeds of sale? Can the company secure its position in some way? Is the extent of any tax issues that any recoupment provision would cause understood? How does the company educate the executives affected and explain to them both the new obligations and the impact they may have?
  6. Start to look ahead in terms of board composition. When members retire take the broader diversity issues into account when looking for candidates; are candidates for executive roles coming from a broad and diverse background? Make sure the NED pool is fit for purpose and meets the increased expectations around diversity; allow the diversity issue to be addressed as a matter of evolution rather than revolution.

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